Market Maker: What is it and How Does it Work?

Author: Iskander Ziyanurov
29.08.2022

Financial markets are often called the fabric that holds our economy together. They have enabled us to move forward in our evolutionary history, for example, by funding the opening of new continents or treating deadly diseases. Different players play different roles in these markets. Still, the market maker is the only player expected to respond to market orders at all times and under all circumstances.

It's generally accepted that market makers are basically high-volume traders such as financial institutions, investment banks, or brokerages that literally "make a market" for assets, always ready to buy or sell at any price to ensure market liquidity. Liquidity plays a crucial role in financial markets, and market makers ensure that the music keeps playing by providing liquidity. Advances in market making have a significant impact on the entire financial industry. Over the past two decades, we have slowly moved toward a more automated financial system. As part of that transition, traditional market makers have been replaced by computers that use sophisticated algorithms and make decisions in fractions of a second.

With the emergence of market makers, the market in its modern sense was formed. Today's market maker is artificial intelligence, which with the help of mathematical algorithms, facilitates a smooth flow of concluded deals and provides instant liquidity. Automated programs that can process up to a million orders simultaneously have certainly become a breakthrough in the world of trading, allowing not only to expand the possibilities when working with trading systems but also, most importantly, to launch an engine for the development of new technologies to increase the liquidity of markets.

In this article, we will discuss what a market maker is, how it works and impacts the market's liquidity, its advantages and disadvantages, and finally, what role it plays in the financial market.

What is Market Maker?

Market makers are special participants of the financial market who keep the market active by constantly being prepared to conclude trades with other market participants.

Market makers may also be defined as traders who, based on an agreement, one of which is the trade organiser, take responsibility for maintaining prices, demand, supply, and/or volume of trades in financial instruments, foreign currencies, and/or goods following such agreement.

Each participant must have a second party involved in the transaction. The one thing you have to do to sell shares or currency is to find someone willing to buy them from you. Likewise, you must find a seller if you want to buy assets. A market maker is responsible for ensuring that no matter what instrument is traded, there is always a buyer or a seller to ensure the transaction runs smoothly.

Market makers can be divided into two categories: Tier 1 and Tier 2 players.

  • 1. Market makers of the first level are considered the largest commercial banks, which are united in a group called Tier 1. Sometimes they are also called institutional market makers (IMM). They cooperate with stock exchanges, conclude agreements and undertake obligations to maintain asset turnover and balance between supply and demand. Besides commercial banks, such providers include organisations that create market movements using interest rates and currency interventions. They can be large banks, dealing centres, brokerage companies, large funds, and individuals with significant capital.

  • 2. Market makers of the second level include intermediaries, facilitating private traders and smaller brokers to enter the market. They operate with their own liquidity but can also borrow funds from the liquidity providers of the first level if necessary. In contrast to ordinary traders, market makers analyse the market, focusing on orders such as Take Profit, Stop Loss, and pending orders. Talking about the categories of market makers, it is worth mentioning that exchange players belong to the class of speculative market makers. These market players have such big stocks of assets (for example, small banks and private investors) that a price impulse is generated when they make transactions.

It is also worth saying a few words separately about market takers. By analogy with market makers, the ones who make or quote prices, market takers are those who accept or take prices. In turn, market makers can make deals only with market takers.

How Do Market Makers Operate? What Is Their Role?

The market makers are responsible for determining how many units of an asset (stock, currency, etc.) will be available on the market. They adjust the price based on the current supply and demand for the asset. By placing orders that can be matched in the future, they provide liquidity for the order book. Once the order has been placed on the order book, the market taker (for example, a trader) uses this position for his own trading purposes.

Generally, market makers have a disproportionately large amount of assets under their control. As a result, they can meet the needs of a high volume of orders in a short period of time at competitive prices. Briefly, they function as a counterparty to any trades happening at any given time, thus taking the opposite side of the trade. Investors should continue to sell as long as investors buy, and vice versa. Brokers offer prices to clients based on quotes provided by one or several market makers in each market.

An understanding of what a market maker does can be gained by considering their functions within the market.

Price Continuity

Liquid markets are characterised by price continuity and a relatively small bid-ask spread. The effectiveness of a market is essentially determined by its reliability. Despite significant volatility, a market maker should be able and willing to set a price in various sizes. This can be accomplished by investing in a variety of distribution channels.

It is imperative to remember that market makers do not provide price consistency out of altruistic motives. Even though it contributes to the market's health, they have their own interests at stake. Without adherence to the price continuity rule, market makers incur losses.

Trade Continuity

Market makers should be able to maintain a continuous presence and respond quickly to market conditions. As soon as an asset is bought or sold, someone must be on the other end of the transaction to ensure it goes smoothly.

Typically, a reputable market maker will facilitate real-time trading so that an institution can offer this service to its clients.

Flexibility and Coverage

Providing flexibility in certain areas enhances the service provided by market makers. Specifically, they can provide non-standard settlement dates and provide multi-currency settlements.

Moreover, rather than focusing on a few assets, a market maker needs to provide its clients with a wide selection of instruments. As a result, it proves that the market makers are committed to satisfying their clients.

Intermediation

There are several ways in which intermediaries can intervene in the market, including:

  • Linking buyers and sellers together.

  • Identifying the opening price.

  • Providing active quotations on two-sided markets. An exchange transaction may only be completed with the participation of a market maker following market rules. Thus, market makers' online quotes can be considered legitimate.

  • Assuring that all participants in the market have access to the latest information. An example is market prices.

  • Making sure that the market remains balanced. When buy orders are overtaken by sell orders at times, it can significantly impact the market. For this reason, market makers use their own funds to ensure a balance in the market.

Based on all of the above, we can conclude that market makers are integral to any financial market, ensuring that a key indicator of any instrument, liquidity, is constantly stable.

How Do Market Makers Make Money?

The critical information that market makers have is the data of the orders received from clients. What is included in this data? Essential parameters such as values of Stop Loss and Take Profit orders, as well as values of pending orders. This information lets the Forex market maker know where the most significant number of orders are accumulated. And this, in turn, allows the market maker to manipulate the price (the higher the number of clients with whom the market maker works, the higher its influence on the market).

To make money on the exchange, you need to correctly predict significant price movements and timely open positions in that direction. Imagine that you could control the price movement, then it would be enough for you to open a buy position and then move the price up. Or the opposite would be true: you could open a sell position and move the price down. Of course, no market maker in the world can handle such large price movements. But to provoke a significant price movement, sometimes even a tiny impulse from the market maker is enough.

So, how do market makers earn in the end? The income of a market maker is made up of three components:

Exchange Commissions

This type of income is possible only for the institutional market maker, which has a contract with the organiser of trades. As an example, a market maker can receive a reward from the exchange as a commission for each completed transaction.

Turnover Earnings and Bid-Ask Spread

Some market participants, from time to time, sell to the market maker at his buying price, while other investors buy from him at his selling price. Since the market maker sets both buy and sell prices with a specific spread simultaneously, his turnover increases significantly. For example, a market maker can still make deals with relatively high turnover even in a calm and stable market.

On the other side, sharp market movements are unpleasant for the market maker. For instance, when the market is experiencing significant sales, the market maker will be forced to buy the falling price assets, but no one will buy assets from him at his offered selling price for some time. Alongside this, the purchases may come back at lower levels. Other market participants will start buying again at the market maker's selling prices, which will be lower than his average buying price during the general market sell-off apart from him. Such periods of sharp movement reduce the market maker's earnings on spread and turnover.

Opening of its Own Trading Positions

Having all the necessary information about the market and its vertical analysis, market makers have more opportunities to make profitable deals than any other market participant.

Advantages and Disadvantages of Market Making

Market makers can offer advantages to investors with smaller and private accounts. The disadvantages primarily affect advanced traders. Among the advantages are the following:

Security Availability

By acting as custodians, market makers allow investors to gain exposure to assets that would otherwise be unavailable to them.

Investor Confidence

Market makers give investors confidence by confirming that assets are worth investing in. Market makers analyse assets from a different perspective than small investors, so their activities serve as a barometer for the overall market.

Seamless Markets

Market makers play an important role in improving the market's functioning by bringing it liquidity and volume.

Despite the many benefits market makers own, it is also worth noting that it has certain disadvantages:

Insider Trading

There's always the possibility that some market makers may use information that's not publicly available and engage in insider trading to make illegal profits, leading to severe regulatory actions and affecting innocent investors.

Conflict of Interest

Since market makers are sometimes involved as both brokers and dealers, this creates a conflict of interest because, as brokers, they are supposed to provide clients with the best execution. In contrast, as dealers, they become the counterparties and are therefore trading for profit. Thus, investors should be cautious.

Impact Market Integrity

Since market makers deal in an incredibly huge number of assets, they can influence the market's price. Due to these actions, investors might engage in herding behaviour, harming the markets and investments. In this regard, the actions of these institutions may damage the integrity of the capital markets.

The Bottom Line

Undoubtedly, although the market maker's role is quite complex in technical aspects, it has real value for the financial markets and exchanges. Market makers have always been one of the most important parts of any financial market, although we usually do not think about the importance of their liquidity function. These participants must maintain fair prices for different assets at any time and ensure that demand is covered. Otherwise, it would be impossible to trade large volumes without long delays when large-volume orders are executed.

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